Return on assets (ROA) helps you determine how much profit your company is making. It is different from the total assets, so calculating it gives you an accurate measure. Return on assets gives an investor, manager, or analyst a clear picture of how well a company is doing and generating earnings. It is a percentage of growth and here we will help you find out by calculating your ROA.
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What is return on assets?
Every business is making things work efficiently by squeezing out the maximum of limited resources. If you compare profits with revenue, it gives you an idea of the clear metric. However, comparing these two with the resources you earned cuts down the feasibility of your business’s existence. Thus, return on assets helps you get the ‘bang-for-buck’ measure and helps you manage your finances better.
How to calculate return on assets?
The average of total assets is found out by calculating ROA as a company’s total assets keep changing with time. For example, when you purchase vehicles or sell old machinery or when you buy land or equipment, when there are seasonal sales fluctuation or inventory changes, everything affects the net return on assets.
Calculating the average amount of total assets for a short time frame can be easier to determine than looking for a longer picture. You can easily find the total assets of your company in a quick balance sheet.
The net profit or income is found right at the bottom of your income statement which is used here as the numerator. Make sure you don’t confuse the net income with net revenue. You need to deduct all the operational costs, production costs, overhead costs, debts, taxes, depreciation, and more before calculating net income. Your net profit is only what you’re accountable for and directly related to primary operating like your investment income, one-time payment for selling assets, and so on.
You can find out the ROA of your company by diving the net income of your business by total assets. So, the formula is:
ROA = Net Income/Total Assets
What is a good return on assets?
If the ROA results are high, it shows more efficiency of the business. It means you have been able to use your resources at its best and extract the benefits of it.
Return on assets example
Suppose Susan and Sam start a costume jewelry business. Sam spends $1000 to put up a stall, while Susan pays $10,000 to get the raw materials. Now assume that these were the only assets they spent their money on. If with time, Sam earned $100 while Susan earned $500, Sam’s earnings will be more efficient than Susan’s.
By using the above formula, you can see that Sam’s ROA is $100/$1000 = 10%, while Susan’s ROA is $500/$10,000 = 5%
The equation is a generic way to help you understand how returns on assets work. It is a more simplified approach but gets larger when you consider each and every penny you’ve invested and got in return.
Significance of ROA
ROA gives you an idea of your earnings generated from your capital or assets. The return on assets for public companies is usually dependent on the industry they belong to. This is why the approach to understand or calculate ROA is a comparative measure. You can get the accurate growth by comparing it with the company’s previous numbers against the current one.
The accurate return on assets measure gives every investor an idea of how effective your company is. It shows how well your resources are getting converted into income. The higher the level of ROA, the better you’ve performed. This is simply because you are earning more money and investing less.
Note that your total assets include the sum total of liabilities and shareholder’s equity. These are different types of financing measures to fund operations in a business. As a company’s assets are funded by equity or debt, there are some investors or analysts who don’t consider the price of acquiring assets by adding the back interest costs while calculating the ROA.
Alternatively, this means, that the impact of having more debt is nullified by adding the back cost of borrowing against the net income. This is done by using the average value of assets within a time frame as the denominator. Here, they also add the interest expense as the net income excludes that.
How is return on equity different from return on assets?
Return on equity (ROE) and ROA are both ways to measure how well a company uses its resources. However, ROE measures the returns on a company’s equity and leaves out liabilities. ROA takes the company’s debts into account while ROE doesn’t. The more debt your company is under, the higher your ROE will be compared to the ROA.
Limitations of ROA
The main problem with ROA is that you can’t use it across industries. This is because a technology industry will have different calculations compared to a company of oil drillers. Their assets bases are separate and that’s what brings in confusion.
Many analysts conclude that the basic formula of ROA is limited and is best suited for financial institutions like banks. The balance sheets in a bank have a more accurate value of liabilities and assets as those are carried at market value and not according to a historical cost. Here, both interest income and interest expense are considered.
St. Louis Federal Reserve gives us data of US bank return on assets’ that have hovered around for more than 1% since 1984. For companies that are non-financial, equity capital and debt are strictly separated just like the returns to every – interest expense is what the debt providers get in return, while net incomes show what the equity investors get in return.
In such a case, the common formula jumbles up and compares returns to the equity investors with assets provided as debt or by the equity investors. There are two possibilities of this formula – fixing the numerator-denominator inconsistency by adding interest expense or back to the numerator.
Option 1: Net Income + [Interest Expense*(1-tax rate)] / Total Assets
Option 2: Operating Income*(1-tax rate) / Total Assets
How ROA is important to investors?
When you calculate the ROA of a business it helps you know the profitability level. You keep a track through multiple quarters and years, you can soon compare it to other companies. However, it is easiest to compare businesses that are smaller in the industry than bigger ones. The bottom line is keeping track and that tends to work when you keep calculating all the monetary inflows and outflows.
Banks tend to have a huge amount of total assets on record in forms of cash, investments, loans, and more. A comparatively large bank might have more than $2 trillion in assets while when it is about any other company, the net income tends to differ. Although banks profit or net income can be similar to another company with high-quality assets. However, this doesn’t determine a large ROA. Thus, when you divide the total assets with net income, you might find a low ROA for financial institution.
On the other hand, auto manufacturing needs lots of facilities and specialized equipment. Again, a profitable software company that makes money on downloadable programs might generate similar net profits but have higher ROA than hardware-based companies.
When you think of such metrics and compare productivity over business. It is essential to take lots of things into accounts. Different types of assets have different values. It all depends on how it works in a given industry instead of just comparing figures.
What are the uses of ROA?
ROA is not a profitability ratio like ROE as it measures every kind of business asset – these includes the ones that come out of liabilities due to creditors, capital paid by investors, and more.
The total assets are like net assets. So, borrowed cash holdings for a business is balanced by a liability. Similarly, a company’s receivables are an asset balanced by the payables. This is why many shareholders don’t take interest in a company’s ROA compared to other financial ratios.
The stockholders take interest on the return of their contribution. But inclusion of assets when derived from equity or debt is what the management is more concerned about. ROA is more of an internal track of assets and its use over time. It helps you monitor the performance or your company and compare how your competitors are doing.
It also makes the results look different in terms of operations and divisions when compared with one to another. To accomplish this effectively, the accounting systems must be in place for allocating assets accurately to different operations.
When you calculate ROA for a certain time frame, it tells you how effectively your assets have been used. If it hasn’t been used efficiently then it is ‘under-capitalization’. When the ROA begins growing in relation to your industry as a whole, you cannot pinpoint the accurate reasons for efficiencies that yield profitability. Also, the favorable signal might be negative or say investing in new equipment could be overdue.
Internal use of finding out the ROA related to evaluating the benefits of investing in another system against expanding the current operations. Of course, the best option will improve productivity and reduce asset costs. But you need to choose wisely.
By now, you know that return on assets is all about the percentage of profit against your total assets by net income. But you also know that there are several determining factors that make your business output different from other businesses. Make sure you hire an accountant who helps you do your finances. It will help you keep track of your income, growth, and how well you use your assets.